Oil - Why not Eco 101 (Or why Eco 101!)

Slightly technical. Skip it if you are absolutely not interested in economics ;0 (Or if you have never ever learnt it).


Does the supply demand pattern that we learn in Eco 101 work with Oil ?

It would seem so. I happen to read a file note recently by an analyst in a top Investment Bank (Dont know if it is still top - it was still Friday afternoon at least!!) taking a contra call by saying oil prices are going to go down in medium term. The reasons appeared very plausible the way he enumerated his logic. At higher oil prices, many hitherto unviable fields (due to logistical issues, high drilling costs etc) will see new drilling using much more advanced technologies and higher investments. Hence more supplies will come online and as we all know from our Eco 101 we shall have lower prices. Brillianto. We can expect lower oil prices soon. Our inflation worries will subside. Rates will be lowered. My EMI will reduce. Yippieee !!!
Since I met up with the author (a reasonably good friend of mine) we had a nice debate on the same. Ive always believed in not using the normative SD curves to predict oil prices. (Even I might be wrong - but well, its my blog ;). And Im not an eco proff atleast as of now :)

My points were :-
1. Normative SD curves for prediction of oil prices has many pitfalls. Assume Im a supplier. I see oil prices going up. I am ready to make investments (huge by the way) to capitalise on the rise. If I can monetize the assets underground currently, early enough I can make a great returns. But I will invest only if one of the following is true
A - Im such a small producer that my additional supplies wont affect market prices. If market prices were to come down by my additional production, I would never invest in the higher cost new technologies since my marginal cost of production will be higher than existing player. Hence a reduction in price would reduce margins for existing players but might wipe me out.
B- Im a large producer. But the demand far outstrips supply that the curve is inelastic.
In either cases, the points put forth by the analyst would not hold merit, i.e prices wont come down.
There is an exception to this. It is that Im a large player such that even with a decrease in price my margins would not get affected significantly . This would be because the market price is set my a marginal producer whose marginal cost of production is way above mine. He will be wiped off. Ill remain in the market with a slightly lower margins. Caveat however is that, good strategic thinkers in market leaders would rather want higher cost marginal producers to remain in market than getting wiped off !
2. Oil assets are value by an index linked to prevailing market prices (It might be spot / forwards - lets skip the details!). If I drill more leading to higher supplies to meet increased demand, my revenues increases (even with a price drop let us assume that the revenues might increase overall). But my valuation is not just a function of my revenues. In case of oil producers, the very same analysts,like my friend above, values their underground reserves too. So along with an increased revenue, the price drop ensures that my reserve valuation decreases. (Since it is linked to current prices or at best an index to futures). Hence even if we assume margins might not get reduced even if prize falls (the price decrease might get offset by a comparable fixed cost reduction due to enhanced economies of scale), my companies valuation might actually suffer. Why would a market savvy CFO allow his COO take that path ?
At the same time if price reduces, I might actually produce more since my underground assets are anyways undervalued. Let me atleast produce more and increase my revenues at the same time hope that the economies of scale will help me combat the margin pressures a bit. Inverse SD curve ?!!
3. Many countries including our dear India doesn't even allow the effects of price increase flow down to demand patterns. By acting as a cushion protecting the common man against increased prices the governments are creating additional imperfections in an already imperfect market. Worse still this keeps opportunity cost for alternative avenues like solar, electric cells very high (Civic hybrid was recently introduced for something like 21 lakhs - What a sad joke!!)

The writing is clear. Oil is not going to come down to historic levels. Going green is the way. Governments must stop acting as sponges soaking away the price signals that can reduce consumption of oil. (SUVs and trucks are getting jacked in US - people shifting to more environmental friendly alternatives). This shall have multiple benefits - cleaner environment, reduced global warming, more investments in green alternatives (No, I DONT mean the other big joke Biofuels!!).
We can continue wishing and dreaming Oil will be back to 30-40 per barrell. (But honestly as a conservationist - albeit armchair for most part - I hope it doesn't!!)

(Taken when I was more an Oil & Gas engineer than a photographer - hence excuse the artistic merits of this shot ;))